Interest rate risk validation of non-maturity account decay rates draws stepped-up scrutiny
By Darryl G. Drewett
Why is my examiner asking about “validation” and “decay”?
The answer lies within OCC Bulletin 2010-1, which sets forth interagency guidance on interest rate risk, along with follow-up Bulletin 2012-5, which answers frequently asked questions on the topic. This guidance recognizes the fact that interest-rate-risk models are extremely sensitive to underlying assumptions.
Among these assumptions are estimates of non-maturity account decay rates. Non-maturity balances are typically made up of checking and savings accounts. Decay is the rate of decline in non-maturity balances as accounts get older.
Over time, the process of decay is like an effective maturity for checking and savings accounts. Even though there is no legal maturity, the fact is that customers spend their money, migrate to other accounts or institutions, or close their accounts for any number of reasons.
So why would examiners focus on decay now, if the guidance dates all the way back to 2010? Lately, they have become more interested in decay because interest rates have been so low for so long. Regulators want to ensure banks are prepared in case interest rates rise, and especially if interest rates move up quickly.
Decay rates for non-maturity accounts are an important part of this picture. Regulators expect each bank to understand what happens to these balances in its own specific institution, especially in the face of large rate changes.
That brings us to the “validation” process. In supervisory terms, validation is the method a bank employs to ensure that its interest-rate-risk measurement assumptions reflect reality. For non-maturity account decay rates, validation first means that a bank gains a thorough understanding of its historical non-maturity account behavior. When rates have gone up or down quickly in the past, what has happened to balances in these accounts?
Next, non-maturity account decay rate validation means that a bank makes sure its interest-rate-risk model assumptions reflect the reality of these historical behaviors. If not, the bank needs to document why the assumptions deviate from the historical data. For example, non-maturity balances may have surged during the low rate cycle, and so a bank may expect some balances to be more volatile than they were in past rate cycles.
Whatever the case, regulators will expect to see explicit documentation of decay rate validation. This should include statistical analysis of actual bank data and records of discussion in the minutes of the asset-liability management committee (ALCO) and the board of directors.
As with all risk measurement processes, decay rate validation should be “commensurate with the size and complexity of the institution.” Regulators do not expect to find a Ph.D.-level statistical dissertation at every community bank.
On the other hand, a bank’s board members and management are expected to understand their institution’s interest-rate-risk exposure. Non-maturity account decay rates are an important part of measuring this exposure. Absent effective validation of decay rates, an examiner may consider interest-rate-risk measurement unsupported and arbitrary. This, in turn, may become a safety and soundness issue.
Fortunately, effective measurement of decay rates does not require exceptional expertise on the part of bank staff. If a bank has sufficient records to document non-maturity account movements in different rate cycles, then there is a basis for understanding decay.
The more detailed the records, the better. At First Federal Bank of Louisiana, we were able to develop meaningful account decay statistics in short order. We used a variety of records, including text reports from past years that were in computer cold storage.
We manipulated data using various standard industry software. All of our work was relatively straightforward. No one in the office had formal statistical training. We carefully documented each step in a memorandum that was included in our ALCO minutes.
Another option for a board of directors is to seek outside consultants to perform a validation exercise. In this case, be sure to remember that the board and management are themselves expected to understand their bank’s interest-rate-risk position, and to study and comprehend the consultant’s work.
Banks can also use industry averages, when available. Regulators will still expect to see validation that the industry averages are applicable to the individual bank.
While the examiners are focusing on decay rates because of the current interest rate environment, there are many other assumptions in interest-rate-risk models. Specifically mentioned in the 2010 guidance are asset prepayment rates, key interest rate drivers and other aspects of deposit price sensitivity. Ultimately, regulators will expect documentation that all of these assumptions are valid for the institution.
So why are examiners asking about non-maturity account decay rate validation? Because understanding these concepts is a part of the sound risk management practices of any bank.